A certificate of deposit (CD) is a savings product that holds a certain amount for a fixed period in exchange for interest. This money must remain entirely untouched throughout the term period, or one will risk penalty fees or losing interest. This period may stretch anywhere from six months to five years. CDs are the safest savings option as they offer higher interest rates than savings accounts as an incentive for lost liquidity.

Features of CD
Opening a CD is similar to opening a bank account. When identifying and signing an appealing CD, one must keep four features in mind-

1. Interest rate- A locked interest rate provides a clear and predictable return on the deposit over time. The bank cannot reduce the interest rate for a later date to reduce earnings.
2. Term- CD term refers to the period one leaves their funds locked. It concludes on the maturity date, following which one can withdraw money without incurring penalties.
3. Principal- This is the deposit amount agreed upon while opening a certificate of deposit.
4. Institution- It is the bank or the credit union where a CD is created. The institution decides the terms of the agreement, which includes early withdrawal penalties, reinvestment policies, etc.

CDs are generally administered like other bank deposit accounts, with either monthly or quarterly statement periods. Interest payments are generally deposited to the CD balance, which continues to compound until maturity.

Types of CDs
The most common types of CDs offered today include-

Traditional CD
Traditional CDs, also known as fixed-rate CDs, are the most preferred type of certificates of deposit. Like a fixed deposit, these come with a fixed interest rate, federal insurance, and strict penalties on an early withdrawal.

Bump-up CD
If interest rates increase after buying a CD, the bump-up CD gives the buyer an option of raising the interest rate. Bump-up CDs usually pay lower rates of interest when compared to traditional CDs. To exercise this option, the depositor must inform the bank beforehand.

Step-up CD
Similar to a bump-up CD, a step-up CD does not require the depositor to ask the bank to raise the interest rate. Instead, it happens on the bank’s end.

Brokered CD
These are acquired through brokerage accounts. They offer better interest rates but are also at higher risk as they are negotiable and can be traded in a secondary market. Therefore, before investing in a brokered CD, it is necessary to check the validity of the agency.

Liquid or ‘no penalty’ CD
The liquid CD allows depositors to withdraw the money before the term concludes without any early withdrawal penalty. These CDs generally pay a lower interest rate than traditional CDs.

How are CD interest rates determined?
The Federal Reserve Board’s Federal Open Market Committee (FOMC) meets every 6-8 weeks to decide whether to raise or decrease the federal funds rate. This rate represents the interest banks pay to borrow money from the Fed. When the rate of interest is low, banks offer lower interest rates on customer deposits. On the other hand, when Fed rates increase, banks offer more competitive interest rates for CDs. When opening a CD, pay close attention to the Fed’s rate-setting plans for the near future, as it can help finalize the best possible rates for the deposit.

Pros and cons of a certificate of deposit
CDs can be instrumental in certain situations. They offer higher interest rates than savings or a money market account. They also benefit customers by paying a guaranteed, predictable rate of interest. It helps avoid volatility and losses that are common with stocks and bonds. Furthermore, CDs are federally insured when opened with an FDIC bank or NCUA credit union. They help reduce spending temptations by locking in a certain amount. However, like all investment and savings products, CDs also have certain disadvantages. As mentioned earlier, they cannot be liquidated before maturity without incurring an early withdrawal penalty or a loss of interest. They typically earn less than stocks and bonds do over time. In addition, CDs only earn a fixed interest rate, even if interest rates rise during the term.

CDs are great for holding emergency funds. They allow people to have sufficient reserves with them and clear the temptation of dipping into them since a penalty is involved. Even though a penalty may be incurred, the idea is that these funds will only be used in case of an actual emergency and not otherwise. Due to low risk and volatility, CDs have become an attractive investment option for those wanting to safely earn more on their savings.